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Slaughter & Rees Report: The Economic Guns of September

The United States and China are on the brink of a major trade war. Here are three principles that should guide U.S. policy leaders’ statecraft at this precarious time.

by Matthew Slaughter and Matthew ReesSep 04, 2018

Happy September. After a very vibrant but very busy spring and summer, we Matts are returning to a monthly swing.

For those of you in the United States, we hope you enjoyed a restful Labor Day long weekend closing out (unofficially) summer. For readers everywhere, we hope recent weeks brought some well-deserved holiday last month.

Every August brings the painful anniversary of the 1914 start of hostilities that degenerated into the tragedy of World War I. Barbara Tuchman’s Pulitzer-Prize winning epic, The Guns of August, conveyed many sobering lessons of that conflict. One was the speed with which cross-border conflict can spin out of control, particularly as the fog of battle clouds principled thinking. Thus did Tuchman quote Helmuth van Moltke, chief of Germany’s general staff at the time, who declared, “Don’t bother me with economics—I am busy conducting a war.”

That myopic thinking, which had disastrous consequences, carries haunting echoes in today’s global economy. The United States and China—the world’s two largest economies—are on the brink of a major trade war. This threatens to harm both countries and to inflict collateral damage on many other nations. The United States has already levied tariffs on $50 billion in Chinese imports. China has retaliated with similarly scaled tariffs on U.S. imports. Now America is threatening a further round of tariffs on $200 billion of additional Chinese imports. On a different front, the North American Free Trade Agreement hangs in the balance, with President Trump tweeting a few days ago that, “NAFTA was one of the WORST Trade Deals ever made … We make new deal or go back to pre-NAFTA!” And on a third front, the United States and European Union are skirmishing over tariffs on automobiles and other products.

The human consequences of today’s trade tensions are, of course, tiny relative to the events of 104 years ago. But to avoid serious economic hardship, leaders must peer through the fog to discern a path to a U.S.-China ceasefire. Here are three principles that should guide the statecraft of U.S. policy leaders at this precarious time.

Yes, Chinese laws and regulations must better protect the ideas and intellectual property of global companies operating there. The examples of IP theft and coercion are legion at this point, and the economic damage to global companies and their workers is serious and well documented. For example, several years ago one of us wrote a piece discussing how stronger IP protections in China could create over 2 million new jobs in America. But American leaders should acknowledge how desperately China needs ideas to fuel sustainable economic growth.

There are only three ways a country can achieve long-run economic growth. It can expand its labor force; it can invest its capital stock; or it can innovate to enjoy growth in its total-factor productivity. For China, faster growth in the supply of labor or of capital is somewhere between unlikely and impossible. Despite the recent relaxing of the One Child policy, labor-force growth in China has ceased (as even the state-run media has acknowledged) and large-scale immigration seems politically infeasible. And in many industries, China has been investing too much thanks to government distortions such as fiscal subsidies. Indeed, some of the industries at the heart of the brewing trade war—such as steel—have seen unsustainably massive amounts of capital investment in (and thus production in and exports from) China.

This leaves innovation as China’s only path to sustainable growth in output, jobs, income—and social stability. We in the United States should support and encourage China moving towards this path. Indeed, this was the path the United States took to economic ascendancy in the 20th century. Robert Solow, in seminal work that ended up being a major reason for him winning the Nobel Prize in economics, calculated that the very large majority of U.S. growth during the first half of the 20th century was driven by innovation and technological progress. Of the rise in real gross domestic product per person-hour in the United States from 1909 to 1949, he concluded that, “It is possible to argue that about one-eighth of the total increase is traceable to increased capital per man hour, and the remaining seven-eighths to technical change.” Looking over the next 65 years, from 1948 to 2013, a recent authoritative study by economist Chad Jones found that for growth in U.S. per capita GDP, about 80 percent was accounted for by greater discovery and development of innovative ideas.

Principle #2: Chinese innovation will benefit the United States, not just China.

China has launched a number of initiatives aimed at boosting its innovation output. The most notable is known as “Made in China 2025” and it’s focused on turning the country into a technology powerhouse. There are indeed some issues with how China plans to meet this goal. And, the legitimate national-security concerns of information-technology innovation need to be vigilantly addressed. But much of the commentary around Chinese innovation frames it as a zero-sum game in which greater Chinese creativity necessarily harms America and the rest of the world. American leaders should acknowledge that in many ways, Chinese innovation will benefit the United States, not hurt it.

China is rapidly becoming a global IP leader – moving into the world’s second spot last year on rankings of international patent applications filed. New ideas created in one country often “spill over” to other countries, such that the social returns to innovation often exceed the private returns to the innovator. For example, Apple was reportedly inspired by Tencent, a Chinese company, to add payment services to its iMessage chat service (Apple has also opened R&D centers in the country).

More generally, centuries of empirical evidence have shown that thanks to comparative advantage, many countries—not just one—can succeed and thrive at the same time in innovative industries. Think of automobiles over the past 125 years, with strong global companies based in America, Germany, the United Kingdom, Japan, South Korea—and more recently China. Yes, sometimes one country’s firms struggle against their global counterparts. But that competition is often one of the most sustainable spurs to further innovation. Look at IT today, with America’s FAANG companies (Facebook, Amazon, Apple, Netflix, and Google) arrayed against China’s BAT companies of Baidu, Alibaba, and Tencent. U.S. policymakers should strive vigorously for market access and national treatment in China for leading U.S. innovators like the FAANGs. But they should not assume—in tone or in substance—that Chinese companies should be excluded from these innovative industries. That is unrealistic and would ultimately be self-defeating for the United States as well.

Principle #3: U.S. tariffs on Chinese imports will hurt most of all U.S. workers.

The biggest losers from trade barriers will be those whom the barriers are supposed to help: U.S. workers. Yes, the aggregate U.S. economy is very strong: unemployment in July was at just 3.9 percent, and growth in GDP in the second quarter hit an annualized rate of 4.2 percent. But don’t be fooled by this cyclical peak of the U.S. economy: the costs of tariffs are real, visible, and growing.

As one of us argued in a recent Foreign Affairspiece online, there is now substantial academic research demonstrating that companies respond to greater policy uncertainty by reducing their hiring, reducing their investments in physical capital and knowledge, and more generally taking less risk. The economic intuition is simple: investments in the future—in physical capital, in new ideas, or in expanded worker training—are inherently risky. Greater uncertainty about the overall future raises those risks, in particular by raising the specter of bad futures in which the hoped-for returns on investments are not realized. This means that greater uncertainty today, even if the bad outcomes are not realized tomorrow, can inhibit today’s investments in capital, ideas, and people.

Especially prone to escalating uncertainty seems to be multinational companies: both the U.S. parents of U.S.-based multinationals and the U.S. affiliates of foreign-based multinationals. In this context, what is essential to see is that these global companies account for outsized shares of U.S. capital investment, R&D, trade, and high-talent immigration that provide the foundation for growth in labor productivity and thus jobs and real incomes.

In 2015 (the last year of U.S. government data currently available), the U.S. parents of U.S. multinational companies undertook in America $700.5 billion in capital investment, 43.3 percent of all private-sector non-residential investment. These firms exported $793.9 billion in goods, 52.8 percent of all U.S. goods exports. And these firms conducted $284.3 billion in research and development, a remarkable 78.9 percent of total U.S. private-sector R&D. All these productivity-enhancing activities contributed to the 28.3 million employees of these U.S. parents (22.9 percent of all private-sector jobs) earning an average compensation of $77,656—about a third above the average for all other private-sector U.S. jobs. These parents also create millions of good jobs in their suppliers. Contrary to conventional wisdom, fully 89.7 percent of all intermediate inputs purchased by U.S. parents—$8.7 trillion—were from other U.S. companies, not foreign imports.

The greater policy uncertainty facing these global firms is, all else equal, surely making them more wary of the United States as the location for their high-knowledge-intensive, high-value-added jobs and activities. Cloud the ability of U.S. companies to assess the future and you dull their ability to create high-productivity, high-paying jobs in America.

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Tuck News features the latest stories about business research conducted by faculty members and business practitioners at the Tuck School of Business at Dartmouth College. Editorials penned by professors are published on the site, as well as regular school updates from Tuck staff writers regarding trends in business education.